I'm in a shorting mood. Maybe it's the fall weather. Maybe it's our recent buy. In any case, I'm eager to sell.
As a refresher, shorting is when you sell a borrowed stock and buy it back later, after the price has declined -- you hope. The downside of shorting is that you're limited to a profit of 100% if everything goes right, but you could lose many hundreds of percent if there is a run-up in the stock. That means that you have to watch your shorts very carefully to make sure they haven't run away from you.
It's a short-term play that's very price-based with limited upside potential. And it's negative. Is that a Foolish way to invest? Jeff Fischer has written that it isn't.
What not to short
While there is an element of trading strategy in shorting, I think that identifying a weakening business is just as important a skill as identifying a strengthening one. You have to be careful not to fall into the traps, of course, such as:
- Shorting "open" situations. These are companies that have the potential to blow away all estimates. However much I might question Rambus (Nasdaq: RMBS) or Qualcomm (Nasdaq: QCOM), they are a couple of super-dangerous shorts. So was America Online (NYSE: AOL) in its early days. I look for safer ground.
- Shorting based solely on valuation. Plenty of people will disagree with me here, but I think it's dangerous. Companies can stay "overvalued" for a long, long time, as the Fool Portfolio demonstrated. It shorted a great business, Paychex (Nasdaq: PAYX), in 1994 because of its high valuation. As you can see from this chart, the stock has done nothing but go up since then. (Krispy Kreme (Nasdaq: KREM) is really tempting on valuation alone, I'll grant, but that's an extreme situation, brought about by a tiny float and a massive short squeeze. You couldn't short it right now if you wanted to.)
What to look for in a short
So what should we look for in a short? We need to look at the business primarily. We want to see the opposite of some of the things we look for in our buys:
- "Closed" situations. We'd prefer our short to be in a mature industry with little high-growth potential.
- High debt-to-cash ratio. That's one thing we loved about our Trump Hotels and Casinos (NYSE: DJT) short -- lots and lots of debt at an extremely high interest rate. When a company's interest payments eat up 17% of its revenue, as Trump's did in 1999, it's not going to get very far.
- The company has jumped the shark. When Trump took on its expensive debt, it really jumped the shark.
Jump the shark
That's right, jumped the shark. It's similar to the Rule Breaker notion of Tweening, but jumping the shark identifies the precise moment when you know that things can only go downhill from now on. Bill Barker (TMF Max) pointed me to a great website devoted to the concept. The term comes from the TV show Happy Days. Fans will remember that, in the beginning of the fifth season, Fonzie went to Hollywood to become a star and ended up water-ski-jumping over a shark. The premise of the website is that this moment marked the beginning of the end for the show, even though it went on for six more years. (This episode was also the first for Fonzie's cousin Chachi. Coincidence? More likely a double shark-jump.)
For some things, of course, the idea itself was the shark-jump. Few would disagree that Joanie Loves Chachi, for example, jumped on Day One. The Larry Sanders Show, conversely, never jumped.
The great thing about "jump the shark" is that you can apply it to almost anything. "Have you smelled Jeff's new cologne? He's really jumped the personal-hygiene shark."
Companies lend themselves brilliantly to the idea. Consider some of the past Rule Breaker holdings. When did Iomega (NYSE: IOM) jump the shark? Many would say that it was the big marketing campaign in 1998. How about 3dfx (Nasdaq: TDFX)? Was it the acquisition of STB Systems? Or was that just the final nail in the coffin, the Death Rattle, like when Richie finally left Happy Days?
The shark-jump is an early indicator. It's not easy to recognize it right away. You really have to pay attention and stay objective. If you can spot it, though, you've got a golden short on your hands.
Short your own holdings
Ironically, then, some of the best shorts you can have may come from your own holdings. These are the companies you follow the most closely and know the most about. If you decide that you're going to sell one of your holdings for a reason other than having a better place for your money (financial mismanagement, poor marketing, slow product development, etc.), why not sell more than you hold? If the situation is bad enough for you to sell, how about selling somebody else's shares, too!
Has one of your companies jumped the shark recently? I'd love to get some good short suggestions! Let's hammer 'em out on the Rule Breaker Companies discussion board. If you're ready to sell your ideal short, but you don't have a brokerage account, stop by the Discount Brokerage Resource Center. (Note: To short a stock, you must have a margin account.)
In the meantime, here's some more fun. Surf on over to WhoWouldYouKill.com to vote for the character you would eliminate from your favorite show. For you more stock-oriented types, take a shot at this poll:
When did Excite@Home (Nasdaq: ATHM) jump the shark, if it has?
- Day One.
- When it acquired Excite.
- When Tom Jermoluk resigned.
- When George Bell resigned.
And, lo, a second, bonus poll!
Who would you kill in the Rule Breaker Portfolio?
- America Online
- The Managers
--Brian Lund, who arguably jumped the shark when he took the pseudonym TMF Tardior.